Radical Gold Underinvestment

Gold remains deeply out of favor thanks to global central banks' extreme money
printing. This fueled a global stock-market levitation that has temporarily
short-circuited normal market cycles, leaving investors infatuated with stocks
to the exclusion of prudent portfolio diversification. This has left them radically
underinvested in gold, which sets the stage for massive mean-reversion buying
when they inevitably return.

Portfolio diversification is an absolutely essential tool for investment risk
management. This simple and powerful wisdom is ancient, as a three-millennia-old
quote from the Israeli king Solomon reveals. He advised, "Invest in seven ventures,
yes, in eight; you do not know what disaster may come upon the land." Indeed
history has proven countless times that putting all one's eggs in one basket
is foolish.

And that doesn't just mean diversifying portfolios across individual stocks,
but entire asset classes. The vast majority of stocks are highly correlated
with each other, and the general stock markets. So when the next major selloff
inescapably arrives, individual stocks are all going to spiral lower together.
While owning different stocks mitigates individual-company risks, it has very
little diversification value in major selloffs.

So throughout the dozens of centuries since the super-wise Solomon opined
on portfolio diversification, the truly smart investors have diversified across
asset classes. While they owned stocks or whatever the equivalent ownership
stake in businesses was in their time, they also owned the local bond equivalent,
real estate, and precious metals. Because of its unique behavior, gold
is the most important diversifier of all.

Stocks are highly correlated with each other, and the stock markets as a whole
are highly correlated with the broader economy. And so are bonds and real estate.
So when the market cycles inexorably turn and a new bear market begins, these
portfolio mainstays all drop together. The precious metals are the only major
asset class with a strong inverse correlation to stock markets, they
thrive when stocks are weak.

Prudent investors have always understood gold's indispensable roll
in portfolio diversification. The best financial advisors throughout history
have recommended all investors have 5% to 20% of their portfolios in gold.
It is the ultimate portfolio insurance, tending to rally dramatically when
everything else sells off. But thanks to the extreme central-bank distortion
in the stock markets today, gold has been left for dead.

Stock markets normally meander in endless
bull-bear cycles, driven by valuations. But in early 2013, the Fed's
unprecedented open-endedthird
quantitative-easing campaign started short circuiting them. The Fed was
aggressively conjuring money out of thin air to buy bonds. And Fed officials
kept on hinting that they would ramp up these debt monetizations if the stock
markets fell materially, greatly altering psychology.

Normally investors are wary of periodic healthy selloffs that rebalance sentiment,
and act accordingly. But with the Fed effectively backstopping stock markets,
this prudence vanished. Every selloff since early 2013 was quickly nipped in
the bud. Buy-the-dippers rapidly flooded back in, usually on direct Fed-official
jawboning. Eventually, investors started believing that serious stock selloffs can't
happen anymore.

So they forgot about prudent portfolio diversification, and moved all their
capital into that stocks basket. They bought into the Fed-fostered fantasy
that the stock markets were essentially riskless as long as Fed policy remained
super-accommodative. So they abandoned gold, leading to today's situation
of radical underinvestment in this essential negatively-correlated portfolio
asset class. This extreme anomaly won't last.

American investors have probably never been close to even having 5% of their
portfolios in gold, the lower end of the historical best practice. But we can
still approximate how much their gold exposure has plunged in these recent
Fed-distorted years. This is evident through comparing two key metrics, the
capital invested in the GLD gold ETF and the collective market capitalization
of the elite S&P 500 companies.

GLD is the world's dominant gold ETF, and acts as a conduit for the vast pools
of stock-market capital to flow into and out of physical gold bullion. It is
the cheapest, easiest, and fastest way for stock investors to get gold exposure
in their portfolios. And of course the S&P 500 (SPX) is the flagship benchmark
US stock index, containing the biggest and best US companies. The contrast
between the two is illuminating.

This week, the gold bullion held by GLD on behalf of its shareholders was
worth $27.1b. Meanwhile the total market cap of all SPX companies was $19,729.8b.
Run these numbers, and it suggests American stock investors' total portfolio
exposure to gold is just 0.14%. That's far too trivial to offer any
portfolio diversification at all. And such radical gold underinvestment is
very atypical, even in the gold-agnostic US.

Back in December 2012 just before the Fed's incredibly-manipulative QE3 campaign
kicked into full gear, GLD's holdings were worth $74.1b. That worked out to
0.56% of the SPX components' market cap. While still low, that was a whopping
4.1x higher than today's anomalous levels. And back in August 2011 the last
time gold was really in favor, this GLD-holdings/SPX-market-cap ratio climbed
to 0.79%.

So even in recent history, relative gold investment as a percentage of stock
investors' portfolios was 5.8x higher than today's levels! This reveals
how extreme today's gold underinvestment by American stock investors is. Their
portfolio gold exposure today via GLD is only around 1/6th of peak levels relative
to stocks, and about 1/3rd of absolute levels in terms of capital invested
in GLD. This is super-bullish for gold!

At some point soon here, these central-bank-levitated world stock markets
are going to roll over hard. History is crystal-clear in proving that central-bank
money printing can only amplify and stretch market cycles, it can never
nullify them. And as investors face the first major
stock-market selloff since way back in late 2011, they are going to scramble
to buy gold. It will be rallying strongly while everything else is falling.

As the vast pools of stock capital start migrating back into GLD, it will
be forced to shunt these inflows directly into physical gold bullion. GLD acts
as a conduit for stock-market capital to flow into and out of physical
gold. That's the only way GLD can maintain its mission of tracking the gold
price. Since the supply and demand for GLD shares is independent of gold's
own, GLD's managers have to actually buy and sell gold.

When GLD shares are being bought faster than gold itself is being bought,
this ETF's price threatens to decouple to the upside and fail to mirror gold.
So GLD's managers must offset this differential buying pressure by issuing
sufficient new shares to satisfy this excess demand. The capital raised is
then used to buy physical gold bullion held in vaults for GLD's shareholders.
Stock capital flows into gold via GLD.

But capital pipelines work both ways. When investors sell GLD shares faster
than gold is being sold, its price will disconnect to the downside. GLD's managers
have to buy back enough shares to sop up this excess supply. They raise the
necessary capital to do so by selling some of GLD's holdings of gold bullion.
So stock capital also flows out of gold through GLD, which is what has happened
in recent years.

Since the dawn of full-strength QE3 in early 2013, investors have wholesale
abandoned gold in favor of Fed-levitated stock markets. This chart shows the
quarterly changes in GLD's holdings, reflecting the massive outflows of
stock investors' capital from gold. This extreme selling peaked in Q2'13, when
GLD's holdings plummeted by 251.8 metric tons as investors fled. That drove
gold's worst quarterly loss in 93 years!

Overall between December 2012 and GLD's recent extreme 6.3-year holdings low
in January 2015, investors dumped so many GLD shares that it was forced to
liquidate 648.5t of gold! That works out to about 25.9t of gold per month.
These epic outflows were so great that they overwhelmed normal gold investment
demand, forcing gold's price sharply lower. Gold was above $1700 right as GLD's
epic selloff started!

Gold investors need to realize how incredibly important stock-market capital
flows have become for prevailing gold prices. The amount of capital invested
in the stock markets is enormous, dwarfing gold. So when stock investors
are buying or selling gold in a big way via GLD, the resulting capital shunted
into or out of physical gold bullion has a dominating price impact. This
is readily evident in this chart.

Note how closely the red gold price correlates with the blue GLD bullion holdings
in recent years. Gold could only rally significantly after GLD's holdings stabilized
and started rising again. This proved true in Q3'13, Q1'14, Q2'14, and Q1'15.
Whenever GLD's holdings were falling, indicating differential selling pressure
on GLD shares, gold slid in unison. The additional gold supply spewed by GLD
came too fast to absorb.

So if you want to know which way gold is likely heading next, look to GLD.
When stock investors have high gold exposure via this ETF, that indicates that
gold is likely in favor and in danger of topping. And when they have low gold
exposure like today, gold is out of favor and likely bottoming. So the best
time to invest in gold is when GLD's holdings are low, since stock investors
have little portfolio-diversifying gold.

And that describes today's conditions perfectly, as the radical gold underinvestment
has manifested in GLD. Thanks to the euphoric global stock markets in recent
months, and investors' irrational belief that central banks have miraculously
eradicated stock-market cycles, GLD's holdings have slumped considerably. This
week they were just 0.7% above their extreme early-January-2015 low, which
is intriguing technically.

GLD's holdings look to be carving a massive double bottom. Even though
gold was weak while central-bank-goosed stock markets surged to record highs
as 2014 ended, GLD's holdings stopped falling. That strongly suggests stock
investors reached selling exhaustion on gold. All of them susceptible
to being scared into selling low had already done so, leaving only buyers.
This next chart zooms in on that bottoming.

As gold fell deeply out of favor in early January 2015, bearish commentary
abounded. Everyone, even most of the long-time gold bulls, was forecasting
major new lows soon. Sentiment was overwhelmingly pessimistic, with all hope
seeming lost for gold. Yet the darkest, most-out-of-favor
times are right when markets are ripe for sharp reversals. And that's exactly
what happened in GLD as investors flooded back in.

As gold itself started surging higher on heavy
buying by American futures speculators, stock investors quickly pounced
on this momentum and aggressively bought GLD shares. Their serious differential
buying pressure catapulted GLD's holdings higher as its managers shunted
all those excess capital inflows into physical gold bullion. So January enjoyed
GLD's best monthly holdings build since November 2011!

And with GLD's holdings once again slumping back down near those same early-January
levels that marked a selling-exhaustion bottoming, another sharp reversal is
likely imminent. Some catalyst is nearing that is going to reignite stock investors'
demand for gold. I suspect it will be a sustained and decisive selloff in these wildly-overextended and overvalued US
stock markets, which is long overdue.

While the Fed hasn't started unwinding any of the past 6.5 years' extreme
bond buying yet, it is rapidly nearing the end of its zero-interest-rate policy
launched in December 2008. This will begin the Fed's first rate-hike cycle in
9 years. Higher interest rates are very damaging to overvalued stock markets,
and this coming rate-hike cycle is exceptionally risky. The Fed has never before
normalized out of zero rates!

As the resulting adverse stock-market reactions and sheer uncertainty mount,
stock investors are going to remember that ancient wisdom of prudent portfolio
diversification. They are going to try and mitigate the growing losses in their
stock-heavy portfolios by shifting some capital back into GLD. And since the
gold market is so small relative to the stock markets, it won't take much capital
inflows to catapult gold higher.

Once this whole mean-reversion process gets decisively underway for the stock
markets and gold, it isn't likely to stop until it has fully run its course.
That means investors have a long ways to go to return their gold portfolio
allocations to more reasonable levels. While gold-skeptic American stock investors
will probably never get to 5% of their portfolios allocated to gold, they will
go far higher than today's dismal 0.14%.

Remember that GLD's holdings have been up to 6x higher in recent years
relative to the S&P 500 components' collective market capitalization. I
have no doubt we will see those 0.79% levels again in the coming years. GLD's
holdings will almost certainly exceed 1% of the SPX's market cap the next time
gold really returns to favor. But to be super-conservative, let's just assume
this allocation grows 3x to 0.42%.

It will probably at least take a full-blown correction approaching 20% in
the S&P 500 to drive stock investors' demand for portfolio-diversifying
gold via GLD that high. It's been far too long since hyper-complacent stock
markets have seen one thanks to the Fed's gross distortions. That would drag
the S&P 500's market cap back down to $15,905.8b. Multiplying that by 0.42%
gold exposure via GLD is very bullish for gold.

This yields GLD's holdings climbing back up to $66.8b. That is nearly 2.5x
more capital invested in GLD than today's levels! And as the sharp gold rallies
in recent years partially fueled by GLD buying proved, that would really light
a fire under gold. Assuming gold was about 25% higher than today near $1500,
still way below its pre-QE3 2012 average around $1675, would yield GLD holdings
back up near 1385 tonnes.

That is nearly double today's levels, yet still barely above December
2012's record of 1353.3t. And even if an SPX correction is not sufficient to
drive this, even if it takes an overdue 50% bear market, so much GLD buying
will massively boost the gold price. Stock bear markets take about a couple
of years to unfold. And even at that pace, this mean reversion higher of GLD's
holdings works out to 28.1t of new monthly buying.

According to the World Gold Council, in all of 2014 global gold investment
demand averaged 68.4t a month. So American stock investors ending their radical
gold underinvestment and returning to GLD could boost this on the order of
40% for a long time. And that doesn't include the big
coming buying from American futures speculators, another large pool of
capital with an outsized influence on gold price levels.

So as today's radical gold underinvestment as manifested in GLD's holdings
inevitably reverses and mean reverts back to normal levels, gold investment
demand is going to soar. This will naturally power gold's price much higher,
unleashing gold's first major upleg of this post-QE era. And the Fed's coming
rate hikes are nothing to fear, as gold
actually thrives in rising-rate and high-rate environments!

While gold and GLD will enjoy great gains as stock investors inevitably return,
they will be dwarfed by those in the left-for-dead gold miners' stocks. Late
last year they were battered down to fundamentally-absurd
levels relative to the gold price which drives their profits. So they are
poised to rally dramatically as soon as gold turns around, with the greatest
potential gains by far of any sector in all the stock markets.

At Zeal we've been aggressively buying the best of these beaten-down gold
and silver stocks in recent months, as have been recommended in our acclaimed weekly and monthly subscription
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The bottom line is American stock investors are radically underinvested in
gold, as evidenced by GLD's low gold-bullion holdings. This is a result of
the Fed's artificially-levitated stock markets of recent years, which duped
investors into forgoing prudent portfolio diversification. As the stock markets
roll over, gold is going to return to favor in a big way. It is the only major
asset class strongly inversely correlated with stocks.

As these lofty stock markets sell off, stock investors will flock back to
GLD. All their differential buying pressure will force this ETF's managers
to shunt great amounts of capital directly into physical gold bullion. That
will really accelerate gold's coming upleg, triggering even more GLD buying.
Investors who buy in ahead of this coming major mean reversion in gold investment
demand stand to make fortunes.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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